CHAPTER 3: INTERNATIONAL TRADE & INVESTMENT THEORY

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1 CHAPTER 3: INTERNATIONAL TRADE & INVESTMENT THEORY JANUARY 2011

2 INTERNATIONAL TRADE & INVESTMENT THEORY CLASSICAL COUNTRY- BASED TRADE THEORIES MODERN FIRM- BASED TRADE THEORY INTERNATIONA L INVESTMENT THEORY MERCANTILISM COUNTRY SIMILARITY THEORY INTERNATIONA L INVESTENT THEORIES FACTORS INFLUENCING FDI ABSOULUTE ADVANTAGE INTERNATIONA L PRODUCT LIFE CYCLE OWNERSHIP ADVANTAGE THEORY SUPPLY COMPARATIVE ADVANTAGE INTERNALIZATI ON THEORY DEMAND RELATIVE FACTOR ENDOWMENT(FACTOR PROPORTIONS) ECLECTIC THEORY POLITICAL

3 1. INTRODUCTION

4 1.1 TRADE DEFINITIONS Trade is the voluntary exchange of goods, services, assets, or money between person or organization and another. Trade will only be complete if both parties of the transaction believe that they will gain from the voluntary exchange. International trade- voluntary exchange of goods, services or assets between residents(individuals or organizations) of two countries.

5 2. CLASSICAL COUNTRY-BASED THEORIES

6 2.1 MERCANTILISM A country s wealth, usually measured by its holding of gold and silver, should be accumulated by encouraging exports and discouraging imports. Practices by- Britain, France, Netherlands, Portugal and Spain. Neomercantilists/protectionists Modern supporters of mercantilism; claim that a country should create trade barriers to protect its industries from foreign competition.

7 2.2 ABSOLUTE ADVANTAGE Introduced by Adam Smith A country should specialize in production and export of goods which it produce most efficiently, that is with the fewest labour hours

8 Example of AA theory: COUNTRY RICE(1 TON) PALM OIL(1 TON) THAILAND 1 WORKER 5 WORKERS MALAYSIA 6 WORKERS 3 WORKERS USES 1 WORKER TO PRODUCE 1 TON OF RICE-MORE EFFICIENT IN RICE PRODUCTION USES 3 WORKERS TO PRODUCE 1 TON OF PALM OIL-MORE EFFICIENT IN PALM OIL PRODUCTION

9 2.3 COMPARATIVE ADVANTAGE Developed by David Ricardo If one country(in a 2-country world) held absolute advantages in production of both products specialization and trade could still benefit both countries

10 Example of CA theory: COUNTRY RICE(1 TON) PALM OIL(1 TON) THAILAND 1 WORKER 2 WORKERS MALAYSIA 6 WORKERS 3 WORKERS THAILAND PRODUCES 1 TON OF RICE AND 1 TON OF PALM OIL MORE EFFICIENTLY THAN MALAYSIA, BUT IS MORE EFFICIENT TO LET MSIA PRODUCE PALM OIL(SINCE MSIA PRODUCES PALM OIL BETTER THAN RICE) RATHER THAN PRODUCING BOTH COMMODITIES

11 2.4 RELATIVE FACTOR ENDOWMENT (FACTOR PROPORTIONS THEORY) By Eli Heckscher and Bertil Ohlin Focusing on resources Countries produce and export goods that require resources(factors) that are abundant and import goods that require resources in short supply Basic considerations: Factor endowments(or type of resources vary among countries) Goods differ according to the types of factors that are used to produce them

12 3. MODERN FIRM-BASED THEORIES

13 3.1 COUNTRY SIMILARITY THEORY Inter industry trade- exchange of goods produced by one industry in country A for goods produces in country B. Eg: Exchange of Thai rice and Msian palm oil Intra industry trade- Trade between two countries of goods produced by the same industry. Eg: Exchange of Japanese rice and Thai rice Most trade in manufactured goods should be between similar per capita incomes and intra-industry trade in manufactured goods should be common

14 3.2 PRODUCT LIFE CYCLE THEORY International product life cycle consists of 3 stages; new product, maturing product, and standardized product Depends on type of countries-innovating firms country, industrialized countries, less developed countries STAGE 1- NEW PRODUCT High purchase power+demand- >new product concept Low production because uncertain level of market size Most output is sold in the domestic market STAGE 2-MATURING PRODUCT Domestic market became fully aware Demand rises Higher international sales rather than domestic sales STAGE 3- STANDARDIZED PRODUCT Competition from other companies Search for low cost production base Demand decreases

15 4. INTERNATIONAL INVESTMENT THEORIES

16 4.1 INTERNATIONAL INVESTMENTS Two categories: Portfolio investments- passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active management or control of the securities issuer by the investor. Foreign Direct Investment(FDI)- Acquisition of foreign assets for the purpose of controlling them

17 4.2 THEORIES OWNERSHIP ADVANTAGE THEORY A firm owning a valuable asset that creates a competitive advantage domestically can use that advantage to penetrate foreign markets through FDI Eg: Intel(Technology)

18 INTERNALIZATION THEORY Explains why a firm would choose to enter a foreign market via FDI rather than exploit its ownership advantages Transaction costs- costs of entering into transaction(negotiating, monitoring and enforcing a contract) Eg: Honda

19 ECLECTIC THEORY FDI will occur when 3 conditions are satisfied: OWNERSHIP ADVANTAGE A firm must own some unique competitive advantage that overcomes competitions Eg: Brand name LOCATION ADVANTAGE Business should be done in a more profitable foreign location than a domestic one Eg: Labour, raw materials INTERNALIZATION ADVANTAGE The firm must benefit more from controlling foreign business activity rather than hiring other local companies to provide service Eg: Hiring locals

20 4.3 FACTORS INFLUENCING FDI FACTORS INFLUENCING FDI SUPPLY FACTORS DEMAND FACTORS POLITICAL FACTORS Firms undertake FDI to lower production costs Customer Access Firms may invest to avoid trade barriers or take advantage of economic development initiatives Logistics Marketing Advantages Avoidance of trade barriers Natural Resources Exploitation of competitive advantages Economic development initiatives Key Technology Customer Mobility